The financial systems of many countries are under more strain than they have been
at any time since the 1930s. Confidence in financial institutions generally
remains weak and risk aversion is very high. Governments in a number of countries
have sought to stem the deterioration in confidence through guarantee arrangements,
recapitalisations, and efforts to improve liquidity in markets and de-risk
bank balance sheets. These responses have prevented widespread failures of
financial institutions, and improved the functioning of short-term money markets,
although the confidence which is the cornerstone of a well-functioning financial
system is yet to be fully restored.

The current difficulties are impairing the normal functioning of the credit supply
process, although business credit growth remained positive in most countries
over recent months. While some tightening of credit conditions is to be expected
given the deterioration in prospects for the world economy, the current difficulties
in the global financial system have significantly increased the risk of a damaging
feedback loop taking hold between the financial system and the real economy.

A central feature of the current environment is a marked increase in risk aversion
and the price that investors demand for taking on a given risk. This follows
many years in which risk aversion and the price of risk were very low. The
initial catalyst for this adjustment was the emergence of losses on sub-prime
loans in the United States, many of which were packaged into securities and
bought by large international banks. Then, the failure of Lehman Brothers in
September 2008 saw a further marked rise in risk aversion around the world
as banks, businesses and households reassessed the structure of their own balance
sheets, and the risks posed by the current degree of leverage. The recent weak
economic data has seen this reassessment continue, with the global nature of
the problems reinforcing the process.

Looking forward, reducing uncertainty and risk aversion are central to resolving
the current problems. Recent announcements in the United States to remove risky
assets from bank balance sheets have been helpful in this regard, although
it will be some time before it is clear whether there has been a sustained
improvement in confidence and the functioning of the financial system.

Profitability and Capital

The difficulties in the global banking system are clearly evident in recent bank
profit announcements. In the United States, institutions insured by the Federal
Deposit Insurance Corporation (FDIC) incurred a collective loss of US$32 billion
in the December quarter, with one in three institutions reporting a loss. For
the year as a whole, profits were down by around 90 per cent on the previous
year. The losses have been most pronounced among the largest institutions,
with the five largest US commercial banks incurring an aggregate loss of US$46
billion over the year to December (Graph
1). In Europe, the aggregate profit of the 10 largest banks is expected
to be essentially zero for the full year of 2008, while the five largest banks
in the United Kingdom reported a net loss, including extraordinary items, of
around £21 billion for the same period. In Japan, the largest banks are
also expected to report losses in the December half.

Reflecting the difficult environment, bank share prices in a wide range of countries
have fallen significantly over the past eighteen months. In the United States,
United Kingdom and Europe, bank share price indices have declined by around
75 per cent since mid 2007, with falls in some European countries exceeding
90 per cent (Graph
2 and Graph
3). On top of the large falls in share prices, 17 of the 50 largest
banks rated by Standard and Poor's have had their ratings downgraded
since September 2008, and 20 are on negative outlook. Credit default swap (CDS)
premiums for banks also remain elevated and, in some of the major countries,
are above their levels following the failure of Lehman Brothers.

One notable aspect of the recent poor profit results for many of the world's
largest banks is the disproportionate share of losses that have been accounted
for by write-downs on securities, rather than higher loan provisions. For example,
according to Bloomberg data, since mid 2007, approximately 60 per cent of the
credit-related losses reported by the top 10 global banks have been accounted
for by valuation losses on securities, even though securities accounted for
only around 30 per cent of their total assets (Graph
4).

These large losses from securities reflect two interrelated factors. The first is
that over the middle part of the current decade, when risk premiums were very
low, many large global banks shifted their balance sheets towards holdings
of securities, and away from loans. At the time, the increased holdings of
securities contributed to the banks' reported profits, with declining
risk premiums leading to mark-to-market accounting gains. Banks also earned
significant fees from originating and structuring these securities and from
active trading in them.

The second is the recent marked rises in the prices of risk and liquidity, particularly
following the failure of Lehman Brothers. When these prices rise, the ‘market’
or ‘fair’ value of financial assets falls, even though the expected
cash flows associated with the asset may have not changed. Indeed, over the
past year it is difficult to explain movements in the prices of many financial
assets simply by reference to changes in the expected underlying cash flows.
It is now clear that many large financial institutions simply underestimated
how far, and how quickly, the price of risk could change. As a consequence,
they significantly underestimated the amount of capital that they needed to
hold against a wide variety of assets and the risks that they were running
as a result.

The deterioration in the economic environment, including the ratcheting up in risk
aversion and uncertainty over the past six months, is evident in the prices
of many financial assets, particularly those that are at the higher end of
the risk distribution. For example, spreads on lower-rated US commercial mortgage-backed
securities, and the price of default protection on sub-investment grade US
and European credits are close to their highest recorded levels (Graph
5). These spreads had been increasing steadily after the emergence
of the sub-prime problems, but then jumped considerably following the failure
of Lehman Brothers, and have risen further this year as the weakness in the
global economy has become apparent. A similar pattern is evident in the prices
of loans associated with leveraged buyouts (so-called leveraged loans), and
securities backed by US sub-prime residential loans (Graph
6). These securities have also been affected by the winding up
of many structured investment vehicles (SIVs), which had previously been important
sources of demand for them.

The marked cycles in the prices of risk and liquidity – and the immediate effect
it has had on financial institutions' balance sheets – is one of
the main reasons why the losses on sub-prime loans in the United States, which
should have been able to be absorbed by the global financial system, have been
so damaging. As risk premiums rise, asset values fall, banks look less stable,
credit conditions tighten and spending by businesses and consumers declines,
reinforcing the feedback loop from the financial sector to the real economy.
Not surprisingly in the current environment, even healthy banks are looking
to restrain balance-sheet growth and, in many cases, reduce the value of their
risk-weighted assets.

In addition to losses on securities, loss rates on loans have also picked up noticeably.
For US banks, write-offs increased significantly across the loan portfolio
in 2008 (Graph
7). Although increases to date have been most pronounced on loans
to households, write‑offs have also increased considerably on loans to
businesses, particularly in the commercial property sector, as economic and
asset price weakness has spread. A similar trend is evident for UK banks, with
write-offs for business loans more than doubling in the December quarter 2008.

Another factor weighing on confidence recently, particularly for banks in Europe,
is the deterioration in the outlook for the banking systems of ‘emerging
Europe’, as many of these countries have large external financing requirements,
including some unhedged currency exposures. The spread between emerging Europe
sovereign debt and US Treasuries has risen from 2 per cent to 7 per cent since
mid 2007, with the bulk of the increase occurring following the collapse of
Lehman Brothers (Graph
8). Sentiment has been most affected for those euro area banks
with considerable exposures to the region – particularly some large Austrian
banks with exposures that collectively amount to around two thirds of Austrian
GDP – although the emergence of yet another area of potential difficulty
for banking systems has weighed on confidence more broadly.

Working in the other direction, one factor that has recently been helping to support
bank profitability is an increase in interest margins. With the intensity of
competition having declined, and many banks seeking to restrain growth in their
balance sheets, spreads between average borrowing and lending rates have tended
to widen. Indeed, over recent weeks a number of large banks in the United States
have cited the widening in interest margins as significantly boosting their
profitability.

Other areas of the financial system are also under pressure. Several large insurers
in the United States and Europe have reported losses in the second half of
2008, reflecting falls in the value of their bond and equity holdings. Share
price indices of insurers have fallen by around 70 per cent since mid 2007,
and CDS premiums have risen sharply, with US mortgage insurers among the most
affected given strains in the US housing market (Graph
9). Hedge funds have experienced record losses of 18 per cent in 2008
and the size of the industry fell by US$525 billion over the second half of
2008 to US$1.4 trillion, with redemption requests from investors adding pressure
to sell assets in strained markets.

Given current conditions, many banks around the world have been seeking to raise
new capital to either cover losses or to strengthen their capital position.
In the initial phase of the crisis, sovereign wealth funds and private investors
were the main source of these funds, although more recently governments have
become the main contributors (see below). Banks around the world are estimated
to have raised around US$900 billion in new capital since mid 2007 –
around half of which has been provided by governments – which is broadly
comparable to write-downs over this period (Graph
10). Write-downs over this period have been largest in the United States,
and for the largest five banks are equivalent to around half of the regulatory
capital that they held in mid 2007.

While capital ratios remain comfortably above regulatory minimums for almost all
banks, investors remain wary about the possibility of further write-downs,
and potential dilution from government equity injections. This wariness, and
the earlier losses incurred by those injecting capital into banks, have made
private investors very nervous about contributing further capital. The lack
of confidence is reflected in sharemarket valuations, with the market value
of many large banks in the United States, Europe and the United Kingdom at
end February having fallen to around half the book valuation reported in their
most recent financial statements (Graph
11).

Efforts to Restore Confidence

The difficulties facing the global financial system have led to unprecedented levels
of public-sector support for financial markets and institutions.

In the initial phase of the crisis, these efforts were largely concentrated on improving
the liquidity of short-term money markets. As banks became reluctant to lend
to one another, other than at very short terms, many central banks significantly
expanded the scale of their money-market operations, widening the range of
collateral that they accept and undertaking repurchase agreements over longer
maturities. A number of central banks have also set up schemes to purchase
outright, or assist banks to purchase, assets including asset-backed commercial
paper (ABCP), commercial paper and selected short-term highly rated assets.

While these various actions have helped improve the functioning of short-term money
markets, spreads on short-term bank paper remain elevated relative to their
levels before the emergence of the sub-prime problems (Graph
12). For example, the cost of 3-month borrowing for US banks is currently
around 100 basis points over the swap rate, down from over 350 basis points
in the wake of the Lehman Brothers collapse, but well above the 10 basis points
prevailing in mid 2007. Spreads in Australia remain much lower than those in
a number of other major countries, partly reflecting lesser concerns about
counterparty risk.

The scale of public-sector support was increased significantly in the wake of the
failure of Lehman Brothers. In the immediate aftermath of the failure, confidence
in many banks was shaken, so a number of governments increased caps on deposit
insurance schemes to provide reassurance to depositors about the safety of
bank deposits. The shock to confidence also saw investors become reluctant
to buy long-term bank debt. In response, many governments moved to provide
guarantees on wholesale funding by financial institutions. These moves followed
the action taken by the Irish Government in late September 2008 to provide
a guarantee on new and existing debt for Irish-based financial institutions.
This decision had a cascading effect, as concerns arose about the ability of
financial institutions that did not have access to guarantee arrangements to
continue to access funding. In the weeks following the Irish announcement,
governments in over a dozen countries, including Australia, followed suit with
wholesale funding guarantee schemes, and bank issuance of guaranteed bonds
under these schemes has been strong in a number of countries (Graph
13). (Further details on deposit and wholesale guarantee arrangements
are discussed in the context of Australian arrangements in Box A: Government
Guarantees on Deposits and Wholesale Funding.)

Another key element in the response to the crisis has been the injection of capital
into financial institutions. In a number of cases – including the US
housing agencies Fannie Mae and Freddie Mac, the insurer AIG and the European
banks UBS, Fortis and Dexia – the capital support has been designed to
deal with a problem in a specific institution. However, as the difficulties
have become more pervasive a number of governments have announced broader schemes
under which institutions can apply for support, with relatively standardised
terms and conditions. The first of these was the US Troubled Asset Relief Program
(TARP), announced in early October 2008. Around US$240 billion of the TARP
funds have been used for capital injections, mainly under the Capital Purchase
Program, where institutions can apply to receive capital equivalent to between
1 and 3 per cent of their risk-weighted assets, up to a maximum of US$25 billion.
In total, 520 institutions have received capital injections through this program.
In February 2009, the US authorities announced a broader plan that includes:
stress testing of major financial institutions and subsequent capital injections
if required; actions to lower mortgage rates and prevent avoidable foreclosures
in the mortgage market; and measures to de-risk bank balance sheets, further
details of which were announced in late March.

In the United Kingdom, the Government has also set up a program to increase the capital
of major banks. To date, Lloyds/HBOS and RBS have received injections under
this scheme, although it is open to all UK incorporated banks with a substantial
business in the United Kingdom, as well as to building societies. The form
of the capital raising for Lloyds/HBOS and RBS was an initial investment of
preference shares, and an underwriting of a rights issue. As the rights issues
for these institutions were heavily undersubscribed, the UK Government took
up large holdings of ordinary equity, which it has subsequently increased by
converting the initial preference share investments into ordinary shares. As
a result, the UK Government has effective control of these institutions with
majority stakes and up to 75 per cent of voting rights. A number of European
countries have also set up general schemes to recapitalise their banking systems,
typically through the government purchasing some form of convertible notes
or hybrid debt securities, rather than purchasing common equity.

Another element in governments' response has been the development of programs
to reduce the risk on banks' balance sheets by either removing certain
types of assets completely or providing insurance against losses on the assets.
These programs also allow banks to report higher regulatory capital ratios
as they reduce the bank's risk-weighted assets.

An early example of this approach was associated with the sale of Bear Stearns to
JPMorgan in March 2008. This involved the sale of US$30 billion of Bear Stearns'
assets to a special purpose vehicle largely funded by the US Federal Reserve,
with the first US$1 billion of losses to be borne by JPMorgan. A broadly similar
approach has been followed by the Swiss authorities in the case of UBS, with
a pool of assets valued at US$39.1 billion having being sold to a special purpose
vehicle, with the first US$4 billion of losses to be borne by UBS. In other
cases, assets have remained on the bank's balance sheet, with the government
providing insurance for a fee, typically paid for by the bank issuing some
form of equity to the government. In the United Kingdom, for example, the Government
has reached an agreement with RBS to guarantee £325 billion of assets
for a fee of 2 per cent, and an agreement with Lloyds/HBOS to guarantee £260
billion of assets for a fee of 6 per cent. In both cases, the institution bears
an initial loss, and 10 per cent of any remaining loss, and the fee was paid
through issuance of a special class of shares. In the United States, broadly
similar arrangements have been set up for Citibank and Bank of America.

More recently, the US authorities have announced details of the establishment of
public-private investment funds (PPIFs) to facilitate the purchase of so called
legacy loans and securities from US financial institutions, involving private
investors bidding for the assets to assist with their price discovery. The
purchase of the loans will involve a combination of equity financing, provided
jointly by the US Treasury and private investors, which can be leveraged up
to six times through the issuance of debt guaranteed by the FDIC. For the securities,
one element involves the expansion of an existing Federal Reserve program,
under which the Fed provides loans for the purchase of newly securitised assets,
to cover the purchase of certain existing mortgage-backed securities (MBS)
and asset-backed securities. A second element of the securities program involves
the PPIFs investing in certain MBS, funded by equal contributions from the
US Treasury and private investors as well as the possibility of a loan from
the US Treasury equivalent to 50 or 100 per cent of equity capital, subject
to certain conditions. The total equity contributions from the US Treasury
for the legacy loans and securities programs is expected to be between US$75
billion and US$100 billion and will be sourced from TARP funds.

The various measures discussed above have been effective in preventing widespread
runs by bank depositors and bank collapses, and there has been a general improvement
in sentiment over recent days. Despite this, there are ongoing concerns about
the value of banks' assets, particularly given the decline in the prices
of many securities and the deterioration in the world economy. Reducing uncertainty
and risk aversion are central to resolving the current problems, with the sharp
drop in confidence and the accompanying increase in the price of risk having
a pervasive and debilitating effect on the financial system and the broader
global economy. The task of developing and implementing a credible policy response
has been complicated by the need to obtain broad political support for major
initiatives, especially when they involve governments taking significant financial
risks and/or controlling previously private businesses. While debate continues
about the best way forward, there is a general consensus that banks'
exposures to risky/troubled assets with highly uncertain future values need
to be reduced, either through the sale of these assets or insurance arrangements.
Without such action, it is likely that investors will continue to be wary about
the future of the affected banks, and management's effort will be disproportionately
devoted to managing these assets. There is also general agreement that troubled
banks need to raise new equity. If balance sheets are ‘cleaned up’
through the disposal of risky assets there is some prospect of the private
sector injecting the capital, but if this does not occur the public sector
will need to do so.

Credit and Debt Markets

The difficulties being experienced in financial systems and the uncertainty about
the global economy have seen banks in a range of countries tighten lending
standards significantly. In the United States, for example, in the three months
to January 2009, almost half of banks reported tighter lending standards for
prime residential mortgages, and around two thirds for loans to large and medium
businesses, even though standards have been tightening since at least 2007
(Graph
14). Banks have also been increasing risk margins applied to borrowers,
in contrast to earlier in the decade when they were reducing these margins
(Graph
15). A similar tightening in credit standards is also evident in the
United Kingdom and Europe, with the deterioration in the economic outlook,
as well as the cost and availability of funds, cited as the major driving forces
behind tightening conditions. An IMF survey of banks involved in trade finance
suggests that costs have increased and conditions have been tightened on this
type of finance, particularly for emerging markets.

Not surprisingly, credit growth has slowed in a range of countries (Graph
16). In the United States, the euro area and the United Kingdom, year-ended
growth in housing credit has slowed to low single digits over the past year,
with negative monthly growth rates having been recorded recently in some countries.
Business credit growth has also slowed in recent months, although it typically
remains positive. This follows a period of rapid business credit growth in
the early phase of the crisis which partly reflected re-intermediation as conditions
in capital markets tightened for many borrowers. The volume of trade credit
provided by banks in emerging markets fell in late 2008, according to IMF data,
consistent with reports that disruption to trade finance has played a role
in the extremely sharp fall in global trade.

The increase in the price of risk and general risk aversion has also dampened fundraising
activity in wholesale markets. In the US, for example, issuance of collateralised
debt obligations (CDOs) and non-agency MBS has been virtually non-existent
as investors remain wary of complex structures or highly leveraged entities
(Graph
17). Issuance of corporate bonds has been stronger in early 2009, as
a narrowing in spreads from the late 2008 peaks and a sharp fall in the risk-free
yield has been met with heavy issuance, predominantly from higher-rated borrowers
(Graph 18).

The slowing in the pace of credit growth and, in some markets, debt issuance reflects
both supply and demand factors. Banks and investors are clearly more risk averse
than they were previously and are seeking to deleverage. They are demanding
more in compensation for the risks that they are willing to accept when extending
funding. However, just as banks and investors have become more risk averse,
so too have households and businesses, and there has also been a marked reduction
in the demand for debt given the uncertain environment. The more risk-averse
attitudes of lenders and borrowers is evident in a sharp reduction in global
leveraged buyout (LBO) activity, which totalled US$129 billion in 2008, down
from US$746 billion in 2007, with activity in the December quarter the lowest
for the decade (Graph
19).

A notable feature of the current environment is that the difficulties in financial
systems have meant that the monetary policy transmission mechanism has become
much less effective in some countries. While central banks have lowered policy
interest rates significantly, a widening in risk spreads has limited the extent
to which reductions have been passed onto many lending rates. In the United
States, while the federal funds rate has been reduced by around 5 percentage
points since mid 2007, the 1-year mortgage rate is broadly unchanged (Graph
20). At the longer end, spreads between 30-year fixed mortgage
rates and government bond rates also widened over the past year, although this
has been reversed quite recently. Similarly, in the United Kingdom, rates on
new 3-year fixed housing loans have declined by around 160 basis points since
late 2007, compared with a fall of around 240 basis points in the equivalent
government bond yield, and variable rates have fallen by significantly less
than the fall in the policy rate.

With interest rates now at, or close to, zero in a number of major countries, some
central banks have begun to augment existing open market operations by purchasing
assets outright without conducting offsetting operations to limit the rise
in central bank reserves. For example, in January 2009, the Federal Reserve
began buying agency-guaranteed MBS outright to bring down mortgage rates. And
in March 2009, the Bank of England began purchasing high-quality assets such
as government bonds, and allowing the resulting cash to remain in the system,
with the aim of boosting broad measures of money and credit and, in due course,
the rate of nominal spending. The Swiss National Bank has also recently announced
measures to boost liquidity that include purchases of private-sector bonds.

Financial Condition of the Household and Business Sectors

A striking feature of the current crisis has been the large fall in household and
business confidence in a wide range of countries. While confidence had already
been declining since mid 2007, it took a further step down following the failure
of Lehman Brothers and the period of intense financial volatility in late 2008
(Graph
21). As a result, both households and businesses have curtailed spending,
adding to the contractionary forces in the global economy (Graph
22). The decline in confidence has also been associated with a reassessment
of the structure of balance sheets, with many households and businesses attempting
to reduce their leverage as asset prices decline and risk aversion rises. While
these measures are sensible from the perspective of an individual household
or firm, collectively these actions are serving to further dampen economic
growth, reinforcing the damaging feedback loop between the financial sector
and the real economy.

An important factor weighing on household and business sector balance sheets has
been falls in property prices in a number of countries. Since their peak, house
prices have fallen by around 10 to 25 per cent in the United States (depending
on the measure used) and by almost 20 per cent in the United Kingdom (Graph
23). There has also been a significant downturn in commercial property
prices, particularly in the United Kingdom, where capital values are around
40 per cent below the peak. This, in turn, is reinforcing the adverse credit
supply loop, by reducing collateral values against which borrowers can secure
their loans.

In this environment of weaker incomes and asset values, the proportions of household
and business borrowers having difficulty making debt payments have increased.
Though the initial rise in US housing loan arrears mainly reflected sub-prime
mortgages – particularly adjustable-rate mortgages as interest rates
rose from initial low rates – arrears rates across all mortgages have
continued to rise (Graph
24). In the December quarter 2008, around 5 per cent of prime
loans were 30 or more days in arrears, while the comparable figure for adjustable
rate sub-prime mortgages was nearly 25 per cent. In the United Kingdom, mortgage
arrears have also moved higher, with 3.8 per cent of prime securitised loans
in arrears by 30 or more days as at January 2009, up by 1.6 percentage points
over the year.

Indicators of financial difficulty have also moved higher among corporations. For
example, Moody's global speculative-grade corporate default rate increased
sharply over the past year, although at 5.2 per cent in February 2009, it remains
below the levels reached in previous recessions (Graph
25). Given the tight financing conditions, indebted firms with
refinancing needs are under particular scrutiny, with weakness in sharemarkets
and investor sentiment limiting the availability of access to equity finance.